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Forbes
Is the SEC too cozy with the fund industry?
The SEC has missed the boat when it comes to creating and enforcing rules that end abusive practices. Heres why the agency may be too tight with an industry it should be regulating.
By Neil Weinberg, Forbes
"The fund industry can be proud of its history of promoting a culture of honesty, integrity, transparency and accountability, and also should be proud of its commitment to strong fund governance and compliance practices."
These are the words of Paul Roye, director of the Securities & Exchange Commission's Division of Investment Management -- the guy who writes the rules for the $7 trillion industry. He uttered them in March, six months before it came out that certain funds had been allowing unethical, possibly criminal, trading to take place in their shares.
Roye's admiration for the industry he regulates is reciprocated. At the same conference Matthew Fink, president of the Investment Company Institute, the fund management lobby, said: "Strong day-to-day regulation by the SEC has protected the nation's 95 million mutual fund shareholders and kept the industry free of systemic scandal for more than 60 years."
The coziness says a lot about how trading rip-offs managed to stay under the radar for so long. The industry's lobbying arm is immensely powerful and is aided by a revolving door connecting the regulated to the regulators. Indeed, Roye and his colleagues at the SEC have known about many of the problems for years -- like lax governance, weak fee disclosure and under-the-table payments between fund firms and brokerages -- but have a long history of making rules that don't solve the underlying problems.
| How not to fix mutual funds | | Fund problem | SEC action | Status | | Poor disclosure of fees to investors. | SEC, General Accounting Office offer competing disclosure plans in 2000. Issue gets bogged down in debate. | Compromise proposal awaits SEC vote. |
Trading costs inadequately disclosed. | SEC in June acknowledges that shareholders poorly understand costs. But describes resolving the issue as "problematic." | SEC calls for further study. |
Fund boards lack independence. | In 2001, SEC rules that majority of board members must be independent; this year concedes loopholes exist. | Seeks congressional authority to fill loopholes. |
12b-1 marketing fees misused. | SEC staff recommends in 2000 that Commission consider amending 12b-1 rules; recognizes problem again in 2003. | Commission has taken no action. |
Fund advertisements misleading. | SEC staff urges revision in way funds advertise their performance in May 2002; bemoans quality of ad disclosures again this year. | Staff working on new ad regulations. |
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It would be unfair to blame Roye for the recent scandals. Even after recent budget hikes, he'll be lucky to add 50 staffers to the 150 now on hand to oversee 8,000 investment-management companies, draft rules, churn out reams of Sarbanes-Oxley-related documents and so forth. Roye's unit does not do the on-site exams of fund firms' books. And the SEC's five commissioners, not its bureaucrats, set the agenda. Chairman William Donaldson came to office in February more focused on hedge funds than mutual funds.
"My client is not the investment-management companies but the investing public," Roye says. "I'm perfectly willing to stand on my record of rulemaking." Roye says he's worked up 16 new fund-related rules this year, a pace he claims no predecessor has achieved. Problem is, even rules adopted years ago haven't made much difference.
Now on Forbes.com
Rules slow to take hold
Take the market-timing issue. Barry P. Barbash, Roye's predecessor, warned in 1997 that funds' pricing policies opened them up to manipulation by market-timers. If a New York fund that owns Japanese stocks uses Tokyo closing prices in setting its net asset value, those prices are a half-day stale by the time the fund closes its books on purchase and redemption orders. Sharp traders, it seems, were exploiting the situation.
In 2001, Roye attempted to stop the timers by requiring funds to implement so-called fair-value pricing, in which trading elsewhere in the world is sometimes used to update stale prices. Still, market-timing remained so prevalent that last summer four New York University professors published an article titled "Stale Prices and Strategies for Trading Mutual Funds."
Another problem: feeble understanding by ordinary investors of the effect of fund fees on their account values. Seven years ago an SEC survey revealed that four out of five investors had no idea how much they were paying in fund fees. In a 2000 study the General Accounting Office proposed tough disclosure rules. The ICI vehemently objected to them. The SEC came out with a proposal more to the ICI's liking later that year. Last December, Roye finally submitted watered-down disclosure rules to the commissioners. The commission has yet to act.
Public vs. private interests
Roye's career path, swinging between the SEC and the industry, is fairly typical in the close-knit community of fund lawyers. Roye went to the SEC in 1979 after earning a law degree. In 1982, he moved to the Washington office of what is now Dechert LLP, a law firm that does a lot of work for the fund business. Roye even joked at the industry's spring gathering that at Dechert he had legal drafts kicked back at him by Paul Haaga, another former SEC funds staffer who now chairs the ICI. Says Haaga, "Paul Roye does a really good job, is conscientious and only listens to me when he thinks I'm right. That people have relationships is good."
Roye returned to the SEC as its funds chief in 1998, replacing Barbash, who is now an attorney at Shearman & Sterling representing money-management firms, including mutual funds. Barbash's two predecessors, Marianne Smythe and Kathryn McGrath, went to law firms and occasionally do mutual fund work.
Mercer Bullard, a rare alum of the SEC's fund regulatory staff to work for shareholders (he founded Fund Democracy LLC, a nonprofit investor advocacy group), says he doesn't believe SEC lawyers pull their punches. "The real problem, he says, "is senior people get outside and have access to schmooze or drop in at the SEC unofficially about a case."
It's a problem Bill Donaldson can't cure in a day.
Copyright 2003 Forbes.com. All rights reserved.
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